Fear the Dark Side of China's Lending Surge

Banks loans designed to spark economic recovery have been channeled into asset speculation, doing more harm than good.

By Andy Xie

(Caijing.com.cn) China's credit boom has increased
bank lending by more than 6 trillion yuan since December. Many analysts think an
economic boom will follow in the second half 2009. They will be disappointed.
Much of this lending has not been used to support tangible projects but,
instead, has been channeled into asset markets.

Many boom forecasters think asset
market speculation will lead to spending growth through the wealth effect. But
creating a bubble to support an economy brings, at best, a few short-term
benefits along with a lot of long-term pain. Moreover, some of this speculation
is actually hurting China's economy by driving asset prices higher.

The current surge in commodity
prices, for example, is being fueled by China's demand for speculative
inventory. Damage to the domestic economy is already significant. If lending
doesn't cool soon, this speculative force will transfer even more Chinese cash
overseas and trigger long-term stagflation.

Commodity prices have skyrocketed
since March. The Reuters-Jefferies CRB Index has risen by about one-third.
Several important commodities such as oil and copper have doubled in value from
this year's lows. As I have argued before, demand from financial buyers is
driving commodity prices. The weak global economy can't support high commodity
prices. Instead, low interest rates and inflation fears are driving money into
commodity buying.

Exchange-traded funds (ETFs) alone
account for half of the activity on the oil futures market. ETFs allow retail
investors to act like hedge funds. This product has serious implications for
monetary policymaking. One consequence is that inflation fears could lead to
inflation through massive deployment of money into inflation-hedging assets such
as commodities.

Financial demand alone can't
support commodity prices. Financial investors can't take physical delivery and
must sell maturing futures contracts. This force can lead to a steep price curve
over time.

Early this year, the six-month
futures price for oil was US$ 20 higher than the spot price. Investors faced
huge losses unless spot prices rose. A wide gap between spot and futures prices
increased inventory demand as arbitrageurs sought to profit from the difference
between warehousing costs and the gap between spot and futures prices. That
demand flattened the price curve and limited losses for financial investors.
Without inventory demand, financial speculation doesn't work.

For some commodities, warehousing
costs are low, limiting net losses for financial buyers. Some commodities can be
used just like stocks, bonds and other financial products. Precious metals, for
example, are like that. Copper, although 5,000 times less valuable than gold,
still has low warehousing costs relative to its value. Some commodities such as
lumber and iron ore are bulky, costly to warehouse, and should be less
susceptible to financial speculation. Chinese players, however, are changing
that formula by leveraging China's size. They've made everything open to
speculation.

There's little doubt that China's
bank lending since last December has driven speculative inventory demand for
commodities. Chinese banks lend for commodity purchases, allowing the underlying
commodities to be used as collateral. These loans are structured like
mortgages.

Banks usually have to be extremely
cautious about such lending, as commodity prices fluctuate far more than
property prices. But Chinese banks are relatively lenient. As an industrializing
economy, China's support for industrial activities such as raw material
purchases for production is understandable. However, when commodities are bought
on speculation, lenders face high risks without benefiting the economy. In some
cases, this practice hurts banks and the economy at the same time.

Speculative demand for iron ore,
for example, is seriously hurting China's national interests. Rio Tinto risked
bankruptcy following its overpriced, debt-financed takeover of Alcan. When iron
ore prices fell by two-thirds from the peak, the market started getting worried
about Rio Tinto's viability, and its share price sank.

Chinalco then negotiated a US$ 19
billion investment in Rio Tinto. After that, Rio Tinto's share price nearly
tripled. Rio Tinto then decided to issue new shares and cancel the Chinalco
investment. Chinalco essentially gave Rio Tinto a free call option, and was
ditched when a better option became available. The issue is why its share price
has done so well.

The international media has been
following reports of record commodity imports by China. The surge is being
portrayed as reflecting China's recovering economy. Indeed, the international
financial market is portraying China's perceived recovery as a harbinger for
global recovery. It is a major factor pushing up stock prices around the
world.

But China's imports are mostly for
speculative inventories. Bank loans were so cheap and easy to get that many
commodity distributors used financing for speculation. The first wave of
purchases was to arbitrage the difference between spot and futures prices. That
was smart. But now that price curves have flattened for most commodities, these
imports are based on speculation that prices will increase. Demand from China's
army of speculators is driving up prices, making their expectations
self-fulfilling in the short term.

The failure of Chinalco's
investment in Rio Tinto has been costly for China. After watching its share
price triple, Rio Tinto saw it could raise money more cheaply by issuing new
shares to pay down debt. The potential financial loss to Chinalco isn't the
point. Rather, higher costs will stem from a further monopolization of the iron
ore market because Rio Tinto, after scrapping the Chinalco deal, entered into an
iron ore joint venture with BHP Billiton. Even though these two mining giants
will keep separate marketing channels, joint production will allow them to
collude on production levels, significantly impacting future ore
prices.

The iron ore market has been
brutal for China, partly due to China's own inefficient system. China imports
more ore than Europe and Japan combined. Skyrocketing prices have cost China
dearly.

For four decades before 2003, fine
iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was
plentiful, prices were driven by production costs. After 2003, Chinese demand
drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per
ton, and the spot price reached nearly US$ 200 a ton in 2008.

The gradual concentration of major
iron ore mines by the world's three largest suppliers was a major reason for
this price increase. The nature of Chinese demand was another major reason.
China's steel production capacity has skyrocketed, even though capacity is
fragmented.

China's local governments have
been obsessed with promoting steel industry growth, which is the reason for
fragmentation. Huge demand and numerous small players are a perfect setup for
price increases by the Big Three miners, which often cite high spot prices as
the reason for jagging up contract prices. But the spot market is relatively
small, and mines can easily manipulate spot prices by reducing supply. On the
other hand, numerous Chinese steel mills simultaneously want to buy ore to
sustain production so their governments can report higher GDP rates, even if
higher GDP is money-losing. China's steel industry is structured to hurt China's
best interests.

As steel demand collapsed in the
fourth quarter 2008 and first quarter 2009, steel prices fell sharply. That
should have led to a collapse in ore demand. But the bank lending surge armed
Chinese ore distributors, giving them money for speculating and stocking up.
That significantly strengthened the hand of the Big Three. The tie-up of BHP and
Rio Tinto further increased their monopoly power. Even though China is the
biggest buyer of ore by far, it has had no power in price setting. The global
recession should have benefited China. Instead, the lending surge worsened
China's position by financing Chinese speculative demand.

China is a resource scarce
economy. Its import needs will only increase. International suppliers are trying
to take advantage of the situation by consolidating. But Chinese buyers are
fragmented due to local government protection. China's lending surge made
matters worse by creating excessive speculative demand.

What is happening in the commodity
market is glaring proof that China's lending surge is hurting the country. Even
more serious is that it is leading Chinese companies away from real business and
further toward asset speculation – virtual business.

The tough economy and easy credit
conditions encouraged many companies to try profiting from asset appreciation.
They borrowed money and put it into the stock market. And since China's stock
market has risen 70 percent since last November, many businesses feel vindicated
for focusing on the asset market. This speculation spread to Hong Kong. Mainland
money may have been behind a recent rise in the Hang Seng Index to 19,000 from
15,000, as well as Hong Kong luxury property sales. One way or another, it seems
the money source was China's lending binge.

Borrowing money for asset market
speculation is not restricted to private companies. State-owned enterprises
(SOEs) appear to be lending money to private companies at high interest rates,
i.e. loan sharking, using money borrowed at low rates from state-owned banks. Of
course, we can't estimate the magnitude of such SOE lending. But it has replaced
high interest rate financing in the gray economy.

As the economy weakened in late
2008, private lenders began demanding money back from distressed private
companies. Loans from state-owned enterprises may have kept many private
companies from going bankrupt. It has served to re-channel bank lending into
cash for individuals and businesses that were in the lending business. This
money may have flowed into asset markets. It is part of the phenomenon of the
private sector withdrawing from the real economy into the virtual
one.

It's worrisome that businessmen
have become de facto fund managers and speculators. This happened 10 years ago
in Hong Kong, and since then the city's economy has stagnated. Some may argue
that China has SOEs to lead the economy. However, private companies account for
most employment in China, even though SOEs account for a larger portion of GDP.
Now, the government is spending huge amounts of money to provide temporary
employment for 2009 college graduates. If private sector employment doesn't
grow, the government may have to spend even more next year. The government is
using fiscal stimulus and bank lending to support economic recovery. But the
recovery may be a jobless one. China needs a dynamic private sector to resolve
the employment problem.

We are seeing a dark side to the
lending surge as commodity speculation hurts the economy. More lending may lead
to higher commodity prices, threatening stagflation. Cheap loans benefit
overseas commodity suppliers, not necessarily the Chinese economy. Lending
policy should consider this self-inflicted damage.

Many analysts
argue GDP growth follows loan growth, and inflation is a problem only when the
economy overheats. This is naive. Borrowed money channeled into speculation
leads to inflation. And China may face a lasting employment crisis if private
companies don't expand.

This lending surge proves China's
economic problems can't be resolved with liquidity. China's growth model is
based on government-led investment and foreign enterprise-led export. As exports
grew in the past, the government channeled income into investment to support
more export growth. Now that the global economy and China's exports have
collapsed, there will be no income growth to support investment growth. The
government's current investment stimulus is tapping a money pool accumulated
from past exports. Eventually, the pool will dry up.

If exports remain weak for several
years, China's only chance for returning to high growth will be to shift demand
to the domestic household sector. This would require significant rebalancing of
wealth and income. A new growth cycle could start by distributing shares of
listed SOEs to Chinese households, creating a virtuous cycle that lasts a
decade.

Putting money into speculative
investments isn't totally irrational. It's better than expanding capacity which,
without export customers, would surely lead to losses. Businesses currently lack
incentive to invest. But many boom forecasters wrongly assume that recent asset
appreciation, fueled by speculation, signaled an end to economic problems.
That's an illusion. The lending surge may have created more problems than it
resolved.

Please contact Caijing Magazine for any inquiries. Reproduction in whole or in part without Caijing's permission is prohibited.
[ICP License: 090027] IDC License:[B2-20040250] Advertising Business License:[京海工商广字第0407号]京公网安备11010502005607号
Copyright by Caijing. All Rights Reserved